Europe 2.0

Ten years ago, Hungary, Poland and the Czech Republic were ideal low-cost manufacturing sites serving Western Europe. Emerging from decades of Soviet mismanagement, their governments offered generous investment incentives and rock-bottom labor costs that drove foreign companies to make direct investments worth billions of dollars. Top-tier electronics manufacturing services companies moved in and built cost-competitive sites on the European Union's doorstep.

In May, these three countries, along with seven others, will join the EU bloc, where costs are far higher. Cross-border material flow and pan-European distribution will improve as trade barriers and customs paperwork fade away. A consumer market that comprises 450 million people will rival the United States in gross domestic product as the EU redraws its frontiers all the way to the edge of Ukraine.

Despite the reconfiguration of boundaries, most EMS companies expect business as usual in the short term. However, some sources believe this is the beginning of the end for the cost advantages that lured manufacturers to Eastern Europe in the first place, setting the stage for a new round of location decisions for EMS companies.

"Those regions are no longer potentially low-cost," said Malcolm Penn, chief executive officer of market research firm Future Horizons (Sevenoaks, England). "Any manufacturer there for pure cost savings will end up eventually moving to China."

In Hungary, top-tier companies such as Elcoteq Network, Flextronics International and Jabil Circuit run robust manufacturing operations and export products throughout Europe. The Czech Republic has succeeded in pulling in high-volume manufacturing plants from such companies as Celestica, First International Computer and Quanta Computer.

Jean-Pierre Belouguet, vice president of sales for Solectron Europe, which runs two factories in Hungary, said EU accession will have an impact on costs, though it won't be instantaneous.

"You may say three years from now the cost of labor [in the new EU member countries] will be pretty much the same as in countries like Portugal, which is the lower-cost end of West Europe," he said. "Definitely [costs] will be higher than today."

In Eastern Europe, living costs have also been rising steadily, making it more expensive for locals and creating pressure for wage increases. Hungary, for example, has a 6.6 percent inflation rate forecast for 2004, more than three times the EU average, according to Hungarian Central Bank Statistics.

"[The new entrants] sense the smell of apparent riches in the EU trough," Penn said. "Every other country that has joined the EU has suffered exactly that problem."

According to figures from Scotland-based MHM, an EMS and OEM consulting firm, the annual wage appreciation forecast from 2001 to 2006 is 9 percent for Hungary, 8 percent for the Czech Republic and 3.5 percent for Poland. MHM consultant Michael Hannon said he believes those figures were not a serious threat to cost competitiveness, but added that "if these countries join the Euro zone, that changes the picture completely."

Some EMS companies downplay the cost-benefits erosion. Jabil Circuit Inc. runs two operations in Hungary and one in Poland, with a total of 5,000 employees doing printed-circuit-board assembly and test for televisions and telecom products. Michel Charriau, Jabil's chief operating officer for Europe, believes wage appreciation can be offset by squeezing further efficiencies out of the company's operations.

Flextronics International Ltd.'s huge Hungarian operation has four plants employing 14,000 people, about 15 percent of the company's total employees worldwide. Humphrey Porter, president of Flextronics Europe, also downplays the cost implications of accession.

"There's a gradual increase of cost as the country is developing," Porter said, but added that compared with Western Europe, accession countries will still be inexpensive.

Value moving East

In the enlarged EU, differences between the cost of manufacturing in the West and East will be in stark contrast. Regulations requiring that a percentage of higher-value-added work be done in the EU will fall away in May. This could favor the new EU entrants, since companies would no longer be constrained by laws limiting the extent of their manufacturing operations in those countries, according to Jabil's Charriau. Some higher-value-added manufacturing could move into the new member states, he said.

In fact, a dramatic shift in total EMS production from West to East Europe, including non-EU countries, is forecast in the short term, according to MHM. In 2003, total EMS production in Western Europe was roughly $20 billion and in Eastern Europe, $14.8 billion. By the end of 2005, the figure for the East is expected to be $24.7 billion and for the West, $20.7 billion.

MHM's Hannon pointed out that two years ago Scotland produced 36 percent of Europe's PCs and now that figure is close to zero. "Most of the production went to Eastern Europe," he said.

Manufacturers of high-end medical and telecom equipment previously shunned what they believed was low-quality Eastern Europe. "At the end of last year, that changed completely, and they are all looking for Eastern European manufacturing," Hannon said.

EMS companies are responding accordingly. Flextronics plans to increase its staff in Hungary by 10 percent this year, and Jabil says it will expand its staff in Eastern Europe by 30 percent.

EU accession has also stirred debate about a potential outflow of skilled labor. For the first time, Eastern European engineers will be able to work in Western Europe without a work permit or visa. An engineer in the Czech Republic could get four to five times higher pay just across the border in Germany. "It's an opportunity for highly skilled Eastern Europeans," MHM's Hannon said.

Engineering graduates in accession countries may migrate as well. The attraction is not only higher wages but also the prospect of doing high-end work in Western Europe, where most EMS companies are keeping their core design teams.

Flextronics' Porter, however, doesn't expect even a small-scale exodus of key personnel. He believes mobility across Europe is limited due to language and cultural barriers. "There certainly won't be any more mobility than we see now in Western Europe," he said. "There is no real pressure [to migrate]."

Design opportunities

Many EMS companies have only started developing their design capabilities and shifting toward the original design manufacturing business model. But EU accession may help to kick-start EMS product design activity in the East. Sources said the engineering skills gap between West and East has nearly closed, but, so far, not one major EMS provider has taken advantage of the long-touted low-cost engineering talent available to do product design.

Celestica Inc., for instance, has 3,000 employees at its Czech operations doing PC board assembly and test and some "limited contract design work, but not full product design," according to chief operating officer Marv Magee.

"Certainly over time [design work] will be a possibility, but it's not the case today," Magee said. He added that more higher-value-added services such as machine configuration and procurement activity will migrate to Celestica's Czech operation over time.

Flextronics' Czech operation specializes in the design of parts of products rather than in full-product design. And Jabil and Solectron are focusing on China rather than Eastern Europe for design.

In Estonia, another EU entrant, Elcoteq Network Corp. (Espoo, Finland), has 60 engineers working in a product repair center. Estonia also does test system design, which is related to product design. Chief executive officer Jouni Hartikainen said the Estonia operations are capable of product design, but Elcoteq hasn't yet assigned that task there. "We are moving in that direction," he added.

Migrating east of the EU

As Eastern Europe steps into the EU, products with high labor content will shift to nations farther east that offer lower costs, sizable markets and plenty of skilled labor.

EMS companies have already discreetly settled into lower-cost soil farther east. Just as Flextronics from Austria drove the company's expansion into Hungary over a decade ago, Flextronics' Hungarian operations nudged management into looking at the area in southwestern Ukraine, where shared language and cultural ties with Hungary smooth business relationships.

"It's kind of a natural thing to be looking at what's on our doorstep," Porter said.

In Ukraine, Flextronics works with two local partners doing PC board assemblies, which are then sent to the company's factory in eastern Hungary, close to the Ukrainian border, for finished box manufacturing. The two Ukrainian facilities, in the cities of Mukachevo and Beregovo, are remnants of state-owned electronics companies that offer sound engineering talent, according to Flextronics.

Porter admits the operation is not growing rapidly. Problems include inefficiency in moving materials and products in and out of the country. "Costs are lower but the various issues eat away at the advantages," he said. "Ukraine has too many issues to be making complete products yet."

Jabil is doing something similar. The company also chose Ukraine and is building a green-field factory in the border town of Uzhgorod that will employ 1,500, Charriau said. Currently, Jabil uses a rented facility to make subassemblies that are sent to its Hungarian operation.

Finland's Elcoteq has also taken advantage of its proximity to a lower-cost neighbor. In 1997, Elcoteq opened a small, 160-em-
ployee operation in St. Petersburg, Russia, that has been producing bulkier telecom infrastructure products that aren't highly time-sensitive, according to Hartikainen.

Telecom design engineers are plentiful in St. Petersburg, which during Soviet times turned out highly skilled engineers for military defense work.

Elcoteq spent several years hammering out logistics and customs flow, and they still present some difficulties. "You've heard the stories about trucks lined up at the border," Hartikainen said. "That can't happen in this business if you want to manufacture on a big scale. Time-to-market and how fast materials cross the border are more important than the cheapest labor."

But Russia has the attraction of low-cost manufacturing--about one-half the costs of Europe--plus a huge domestic market that many expect will take off rapidly. A recent report by Pyramid Research Inc. noted that Russia will see dramatic mobile-market growth, to 65 million subscribers by the end of 2007, about double its 2003 level. Nokia, a big Elcoteq customer, recently pinpointed Russia as one of the world's growth drivers for mobile phones.

Elcoteq said it will expand the St. Petersburg plant when its customers see big enough domestic volumes. Export to the European Union is also a possibility. "We have high hopes for the St. Petersburg operation," Hartikainen said.

Solectron in 1997 set up an assembly plant in Timisoara, Romania, about 60 miles from the Hungarian border. Alcatel also runs a 1,000-person operation there, turning out telecommunications products and developing software for Romania and the Balkans. Timisoara, in the Transylvania region, shares language and cultural ties with Hungary.

"The strategy was to go somewhere where we wouldn't have to move again in 10 years," Solectron's Belouguet explained. "The intent was to leapfrog over Hungary, Poland and the Czech Republic, which were very popular at that time."

Today the substantial operation employs 5,000. Solectron does PC board assembly and tests of high- and low-range complexity at the Timisoara plant. Much of the output is trucked to Hungary, where it goes into a final product.

Timisoara has a 50,000-student university, skilled labor and wages about one-half those of the new EU member countries. Still, adjusting to a market economy is taking time in some of these Eastern European countries. "They need to learn how to work in the new economy," Belouguet said.

If it all sounds a bit familiar, it is. A little over a decade ago, the Czech Republic, Hungary, Poland and the other new EU members were worse off and had no model to follow. Sending a fax was problematic, cigarettes were a type of currency and border delays were counted in days.